Since early 2001, New York State has endured a national economic recession, a severe stock market slump, a horrifically destructive terrorist attack and a historic plunge in tax revenues. Yet during the same period, the state’s budget has risen faster than the cost of living—supported, in part, by an enormous tax increase.

Under the most conservative fiscal scenario for 2004-05, state spending will continue to increase at twice the inflation rate over the next three years, giving rise to sizeable future budget gaps even if the economy grows as expected.

What factors have been driving the increase in state spending since 2001?

Which factors will drive it higher in the year ahead?

And what could cause the budget to grow even faster than projected?

The answers include:

Medicaid. State-funds expenditures for Medicaid are up 26 percent (about $1.8 billion) since the end of fiscal 2001[1] and are projected to rise by another $672 million next year.[2] But this figure could end up approaching $1 billion, if (as seems very likely) the Legislature rejects most of Pataki’s proposed cost-containment actions.

School Aid. At just over $14 billion, school aid is easily the largest category of spending in the state funds budget. It rose another $1.3 billion (10 percent) during the last three fiscal years, which represented a slowdown from the much faster pace of the late 1990s. Looking ahead to 2004-05, the question is not whether the Legislature will add to the Governor’s proposed $278 million school aid increase, but by how much.

Debt Service. After decreasing in recent years, the cost of interest and principal on the state’s long-term debt is rising steeply, thanks to an increase in bonding.

In addition to these factors, the latest budget projections do not even begin to reflect the full impact of a court-ordered change in the school aid formula for New York City, or of possible increases in pension fund expenses and contractual salary hikes for state employees.

The sales and personal income tax rates enacted by the Legislature in 2003 are scheduled to expire at the middle and end of calendar year 2005, respectively.

The bottom line: Unless something is done to curb spending, the scheduled “sunset” of the 2003 tax hikes will be very much in jeopardy.

This memo examines in more detail the growth in the budget and what’s causing it.

“Ever Upward”, No Matter What?

New York’s state motto—Excelsior—means “Ever Upward.” That’s an apt description of the state budget in most years—in good times and bad. The chart below illustrates changes in some key indicators from early 2001 through the spring of 2004.

Changes in Key New York State Fiscal and Economic Indicators, 2001-2004

NOTE: Private employment base = Month of January, non-seasonally adjustedBasis for Tax and Budget Figures is FY 2000-01 (actual) through FY 2003-04 (estimated)Sources: New York State Executive Budget, U.S. Bureau of Labor Statistics

As of January 2004, private sector employment in New York State was still 286,800 jobs (4.1 percent) below the peak level of three years earlier. In the wake of the steepest percentage drop in New York State tax receipts since the Great Depression, current tax revenues at the end of the 2003-04 fiscal year will still be nearly $2 billion (or 4.4 percent) below the fiscal 2000-01 level. The consumer price index for northeast urban regions over the past three years has risen by just under 8 percent. But the state funds budget has grown by over $6 billion, or 11 percent.

How can the state be spending so much more if its tax receipts are still below the levels of three years ago? The answer is illustrated by the chart that follows.

The Spending Trend: "Excelsior"FYs Ending 1995-05

* Estimated** ProjectedSource: New York State Executive Budget

As shown above, Governor Pataki and the Legislature have financed the continuing expansion of state government since 2001 through a sharply increased reliance on “miscellaneous receipts,” a category that includes such items as Lottery and video gaming revenues, SUNY and CUNY tuition, off-budget Health Care Reform Act (HCRA) funds, fees and bond proceeds. The latest figure includes proceeds from the spring 2003 sale of more than $4 billion in bonds backed by New York State’s share of the national tobacco settlement.

Adjusting for some timing anomalies in prior-year spending,[3] miscellaneous receipts in 2003-04 are expected to total $17.7 billion, nearly double the 1998-99 level. In other words, the state is more dependent on the sort of revenues that don’t—and, in most cases, shouldn’t—grow steadily with the economy. That makes it all the more important to hold spending down until the economy can catch up with the budget—but the Governor and the Legislature are now on the opposite path.

Governor Pataki initially proposed a 2003-04 budget with no growth in state funds spending,[4] but the Legislature ultimately overrode his vetoes to approve additional spending of well over $2 billion, financed by a supposedly temporary increase in personal income and sales tax rates. Including sales and business tax increases the Governor himself had proposed, the three-year impact of the tax hikes was valued at $5.4 billion, easily exceeding the total raised by all of the tax increases passed during Mario Cuomo’s last five years as governor (1989-94).[5]

In a turnabout from his 2003 stance, Pataki’s budget proposal for 2004-05 incorporates the Legislature’s 2003 spending and tax increase and calls for a further spending increase of more than 5 percent. Even after adjusting for some timing and accounting quirks that inflate next year’s number, the spending hike was one of the largest proposed in Pataki’s 10 Executive Budgets since 1995.[6]

If present trends remain unchanged, spending over the next three years will remain out of line with other indicators, as illustrated below.

Projected Changes in Key New York State Fiscal and Economic Indicators, 2004-2007

NOTE: Private Employment Base = January 2004, non-seasonally adjustedTax and Spending Figures are for Fiscal years Ending 2004 (estimated) through 2007 (projected)Source: New York State Executive Budget, U.S. Bureau of Labor Statistics

New York State’s private employers are expected to add about 240,000 jobs over the next three years, according to Division of the Budget (DOB) projections, which would still leave the job count slightly below its January 2001 total. The state funds budget is projected to rise by over 5 percent a year, compared to average inflation growth of just over 2 percent. Net tax receipts are projected to increase almost as fast as spending on a percentage basis—nearly 15 percent. However, the total projected three-year tax gain of $6 billion will be well short of the projected $9 billion growth in the state funds budget.

Pataki’s 2004-05 Executive Budget forecasts general fund budget gaps of $2.8 billion and $4.3 billion for fiscal years ending in 2006 and 2007, respectively. More than $3 billion of the projected $5.7 billion general fund spending hike in those two years stems from projected increases in Medicaid and welfare costs. Roughly one-quarter of the gap in fiscal 2006-07 is attributable to the scheduled phase-out of tax increases during the previous fiscal year.

These gaps are estimated only for the general fund, which excludes many dedicated taxes, fees and user charges that are counted within the broader state funds category. However, the projected state funds trend closely tracks the projected general fund trend. Absent an unexpected surge in miscellaneous receipts, it’s clear that state funds receipts also will fall far short of projected spending in both years.

Sources of new spending

The chart below illustrates the factors that have driven state funds spending over the past three years.

As shown, Medicaid accounts for nearly one-third of the total state funds budget growth since the end of fiscal 2001; Medicaid and school aid combined generated over half the increase. The final phase-in of STAR, the state-subsidized school tax exemption, represented another big chunk of growth, along with spending increases by the state’s two public university systems, reflecting increased enrollment and higher tuition and fees.

The next chart shows the factors driving the spending increase in Governor Pataki’s proposed 2004-05 budget.[7]

Medicaid is still the biggest single piece of the budget increase, but is down to one-fifth percent of the total increase under the Governor’s proposal. Another large chunk of the spending increase will come in form of new bonds issued for regional economic development projects, some of which have been in the pipeline for several years. Most notably, the pie chart of new spending for 2004-05 reflects the emergence of debt service as a significant new factor driving budget growth in each of the next several years.

Debt service—interest and principal payments on the state’s bonds—directly reflect an upsurge in long-term borrowing, as illustrated in the chart that follows.

NOTE: Figures for FY ending 2004 are estimates; figures for FYs 2006 and 2007 are projectionsSource: New York State Executive Budget, State

The decline in state debt service from fiscal 2000-01 through 2002-03 reflected falling interest rates and the Governor’s use of nearly $1 billion in surplus funds to retire higher-interest debt in 2000 and 2001. The $1.3 billion projected increase in debt service over the next three years tracks the growth in outstanding state-supported debt, which has risen $3.4 billion over the past two years and is projected to increase another $2.9 billion over the next three years. [8]

Clouds on the horizon

As noted, the Legislature is likely to add more spending—perhaps significantly more—to Governor Pataki’s 2004-05 budget plan before it is finally enacted. These figures do not even reflect three other factors that will add to the pressure on the budget over the next few years:

* A 2003 Court of Appeals ruling held that the state’s school aid to New York City has been insufficient to meet the constitutional requirement of a “sound, basic education.” Unwilling to redistribute aid within the existing formula (even though New York already leads the nation in per-pupil school spending), legislators and education lobbyists generally view the court decision as a mandate to raise school aid across the board, and not just for New York City. The Governor hopes to limit the fiscal damage to about $2 billion, financed entirely by a further expansion of state-sponsored video lottery terminals. But the plaintiffs in the case, known as the Campaign for Fiscal Equity (CFE) are seeking much more: a $9.6 billion increase within four years, 90 percent of which will be financed by the state.[9]

* Pension costs for government employers throughout New York have been skyrocketing for the past two years, reflecting the stock market downturn of 2000-02 and costly pension benefit enhancements enacted by the Legislature in 2000. Because the state government is on a different fiscal calendar and is statutorily empowered to temporarily delay higher pension billings, the impact has yet to be fully felt by the state budget. Governor Pataki’s 2004-05 proposal reflects a modestly increased pension contribution of $184 million, based on the assumption that the Legislature will adopt his proposal to stretch out the replenishment of the pension funds over a longer period of time. But state Comptroller Alan Hevesi, sole trustee of the pension funds, says the Governor’s plan would be unconstitutional. Under the comptroller’s approach, state pension costs would be slightly higher in 2004-05, but could rise by hundreds of millions of dollars above the Governor’s projections in future years.

* If Pataki’s tentative contract settlement with the Civil Service Employees Association (CSEA) becomes a pattern for all state workers, annual wage and salary costs will rise by roughly $350 million in 2004-05; $526 million in 2005-06; $839 million in 2006-07; and $1.2 billion in 2007-08 (when the final salary increment takes effect).[10]

The revenue side—little relief

The tax revenue projections in the Governor’s budget assume a moderate economic recovery over the next few years, well within the consensus of most independent economic forecasters. Governors traditionally open the annual budget process with conservative revenue estimates, which in turn are contested by legislators eager to spend more. This year the middle ground of the competing Senate Republican and Assembly Democrat revenue estimates would add no more than $427 million to projected tax receipts for fiscal years 2004-05—an amount likely to be more than offset by the Legislature’s desires for increased school aid and health care spending.

Implications for New York’s economy

Significant state tax reductions, including an historic personal income tax cut, helped boost New York’s economic recovery during the later half of the 1990s. But as the national economy strengthens, New York’s relative performance in the years ahead will be impeded by the higher marginal income tax rates and increased sales taxes imposed last year. Under current law, the temporary top state income tax rate of 7.7 percent expires at the end of 2005, along with a second-highest bracket rate that now affects many middle-income households.[11] The temporary added sales tax of 0.25 percent on all purchases expires in mid-2005.

The highest priority for the Governor and the Legislature should be to repeal these tax hikes on schedule, if not sooner. But given the trends outlined above, this will require a significantly stronger effort to restrain the growth in state spending—including Medicaid reform, changes in state employee benefit structures, reduced borrowing and resistance to the education lobby’s demand for a blank-check school aid formula. Such policies also would have a positive ripple effect on New York City and other local governments.

In short, what New York State most urgently needs is a return to the more consistently tight-fisted approach of Governor Pataki’s first three years in office, when the state budget didn’t increase at all.

Notes

New York State’s fiscal year runs from April 1 to March 31.

About $390 million of the state spending increase on Medicaid for 2004-05 reflects the elimination of $390 million in one-shot federal assistance in this category during 2003-04.

The 2003-04 budget includes $1.9 billion in local aid payments that were delayed from 2002-03 pending approval of a plan to securitize more than $4 billion in state tobacco settlement revenues; thus, for comparison, this money should be counted among miscellaneous receipts for the prior year.

The Executive Budget contains a three-year financial plan, but does not provide a detailed programmatic breakdown of state funds spending for the two “out years” – in this case, 2005-06 and 2006-07.

The chart does not include more than $4 billion in bonds backed by the state’s share of the national tobacco settlement. This technically is not classified as state-supported debt, but the roughly $400 million in debt service payments generated by tobacco securitization will become the state’s responsibility if major tobacco companies default on their scheduled payments for any reason.